JPMorgan Forgot to Tell Clients It Wanted to Make Money

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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JPMorgan Chase Bank is in the business of, among other things, investing rich people's money for them. It charges them a fee for this service. It invests a lot of their money in mutual funds. The mutual funds also charge fees. If the mutual funds are run by JPMorgan, then JPMorgan gets both fees. If they're not, it only gets one fee. Two fees are more than one fee. JPMorgan invests some of its clients' money in its own mutual funds, and some of it in outside mutual funds, but it says: "We prefer J.P. Morgan managed strategies unless we think third-party managers offer substantially differentiated portfolio construction benefits."

Here is how JPMorgan describes the reasons for that preference, or rather, strictly speaking, how it describes some reasons for that preference and one other random thing:

We prefer internally managed strategies because they generally align well with our forward-looking views and our familiarity with the investment processes, as well as the risk and compliance philosophy that comes from being part of the same firm. It is important to note that J.P. Morgan receives more overall fees when internally managed strategies are included.

The first sentence lists the reasons; you can tell because there's a "because." The second sentence is just "important to note." JPMorgan gets "more overall fees" for recommending its own funds, but that's not the reason it does it. That's just something to note, like an unusual bird or a pretty cloud. It exists absolutely, with no causal connection to anything else.

Should you believe that? Umm. At what level? I think it is reasonable to assume that the people in charge of JPMorgan, as a group, want to make money, and that they would prefer to make more money rather than less money. I think it is reasonable to assume that, as a group, they also want their clients to be happy and make money and invest in good funds. And I think it is reasonable to assume that, as a group, they think that JPMorgan funds are good funds that should make their clients happy. It is a pleasant synergy, to sell products that you think are good and get paid well for them.

On the other hand, it is a miserable slog to sell products that you think are bad because your boss gets paid well for them, and at least some JPMorgan advisers seem to have had misgivings:

“We were not able to do the right things for our clients,” said Brad Scott, a financial adviser who quit JPMorgan in April 2012 and now works at LPL Financial. Mr. Scott said that an executive told the brokers on a conference call, “You are not a money manager; you are an asset gatherer.”

So, you know. At some abstract level, it's easy for probity and profit-seeking to coexist. If you make your clients happy, they will like you, and you will make money. That's the essence of capitalism. But any company that sells things to customers for money will frequently run into situations where what's good for the customer is different from what's good for the money. Figuring out how to manage those situations, and to balance the goal of making clients happy with the goal of making them pay, is also pretty close to the essence of capitalism.

Anyway, today the Securities and Exchange Commission and the Commodity Futures Trading Commission announced $307 million worth of settlements with JPMorgan over this sort of stuff. I say "this sort of stuff" very loosely, though. JPMorgan wasn't punished for recommending bad products to clients, or for charging excessive fees, or for letting its financial interests sway its recommendations, or anything substantively bad. It was just punished for describing its conflicts of interest poorly. That language that I quoted up top, about JPMorgan's preference for its own products, is relatively new. Here's how the CFTC summarizes the problem with JPMorgan's old disclosure:

JPMCB disclosed that it had a conflict of interest when it invested its clients' discretionary portfolio assets in Proprietary Funds (because such investments increased revenue to JPMCB affiliates). In addition, clients were informed of which funds were included within their discretionary portfolios, as well as the amount of assets held in each fund by means of, for example, periodic account statements and client reviews. However, no account opening document or marketing material disclosed to IM account clients (including those with GAP IM Holdings) JPMCB's preference to invest client assets in certain Proprietary Funds, namely mutual funds, from February 2011 to January 2014, or in certain other Proprietary Funds, namely hedge funds, from at least 2008 to January 2014.

You can just ignore the abbreviations. The point is that JPMorgan:

Told clients that it would invest their money for them;

Told them that it made more money when it invested their money in its own mutual funds than when it invested in other companies' mutual funds; and

Told them which mutual funds it invested their money in; but

Didn't explicitly tell them that it preferred to invest their money in its own mutual funds.

Anyone with even a hint of cynicism in their psychological makeup will read "we make more money by doing X" to mean "we prefer doing X." JPMorgan disclosed that it made more money from its own funds. You could very easily have read that disclosure and concluded, correctly, that it preferred to invest its clients' money in its own funds. But perhaps some of its clients utterly lacked the gene for cynicism, or perhaps that's just the SEC and CFTC. In any case, for a few years, JPMorgan didn't explicitly disclose that it preferred its own funds, so now it has to pay $307 million.

From the bloodless language of the SEC and CFTC orders, that penalty might seem a bit harsh. For one thing, it's way more than the extra profits that JPMorgan made by doing this, which by the SEC's calculations was $127.5 million, though honestly I have not the faintest idea how the SEC calculated that, or how you should calculate it. For another thing, some of the disclosure failures were accidental: JPMorgan did tell its private bank clients about its preference for JPMorgan funds between 2006 and 2011, and then again starting in 2014, but it "mistakenly removed" that language from its disclosure statement in early 2011 and forgot to put it back in for three years. Also, again, cynicism: If you knew that JPMorgan made more money from its own funds, you could have made perfectly reasonable inferences about its preferences that turned out to be correct.

But you can't tell if that penalty was too harsh just from the bloodless language of the SEC and CFTC orders. That language is negotiated just like the fines are, and there's no requirement that it tell the full story. Perhaps this is a story about innocent, accidental, and frankly pretty trivial omissions in JPMorgan's disclosure that were over-penalized by regulators who are drunk on big bank fines. Conversely, though, it could be a story about JPMorgan violating its fiduciary duties, putting its desire for fees above the interests of its clients, and investing their money in JPMorgan funds instead of better and cheaper external funds. There is not a whisper of evidence for that story in today's settlements. But previousnewsarticles, and a purported whistleblower's criticisms, are not about the nuances of disclosure; they're about whether JPMorgan violated its fiduciary duties to its clients by prioritizing fees over performance.

I assume that, if the SEC had found piles of e-mails in which senior JPMorgan executives explicitly said things like "I know these funds are bad but you should invest your clients' money in them because we make more money that way," those e-mails would have found their way into the settlement orders, and probably the fines would have another digit on them. So I assume there were no such e-mails, and that any conflicts of interest were subtle and implicit rather than gross and scammy.

The bigger lesson, though, is about how hard it is to police these conflicts. Oh, sure, sometimes the SEC goes after them, in egregious cases. But for the most part, you can't expect regulators to second-guess the reasons behind advisers' decisions. How can the SEC or the CFTC know if JPMorgan recommends its own funds because "they generally align well with" its "forward-looking views," or because it makes more money that way? The answer, surely, is a bit of both, and the balance between them is locked away in the hearts and minds of JPMorgan's advisers. It is JPMorgan's job to get that balance right. If it does that job well, then its business will flourish; if it gets too greedy, then customers will go elsewhere. Or that's the theory.

No one entirely trusts that theory to work in the investing business, though, which is why it's so heavily regulated. But the regulation operates mainly in the form of disclosure, and that disclosure can never entirely do the trick. When JPMorgan disclosed that it made more money from its own funds, it told investors pretty much all they needed to know about its potential conflicts of interest, if they were paying attention. Now it discloses a bit more, including that it prefers its own funds, and investors who are paying attention will, I guess, have a bit more to pay attention to. Investors who are not paying attention will be no more informed by the new disclosure than they were by the old one. Either way, they will stay with JPMorgan if they trust it to look out for them, and they won't if they don't, and they probably won't make that decision based on the disclosure. And managing the conflict between helping clients and making money will remain mostly a business problem, not a compliance one.

Many of J.P. Morgan's products have performed well. Some 76% of its stock funds have beaten their peer-group average over the past three years as of July 31, according to Morningstar Inc., a fund-research firm.

See page 11 of the SEC order, on the $127.5 million disgorgement, "which represents profits gained as a result of the conduct described herein." I don't think that is even meant to suggest that it's a serious effort at a calculation. The CFTC order (page 8) contains a $60 million disgorgement provision, but that can be offset against the SEC one, so the total disgorgement is just the $127.5 million, plus $11.8 million of interest and $167.5 million of total fines.

There are a couple of other disclosure failings mentioned in the SEC order, including about share classes of mutual funds and about retrocessions from outside hedge fund managers, that probably weren't as easily discoverable from first principles.

Oh, right, fiduciary duties. Generally speaking, brokers do not owe fiduciary duties to their customers, while registered investment advisers do; JPMorgan employs both. (And it employs people who are registered both as brokers and as investment advisers. For instance, Johnny Burris, a whistleblower on these issues about whom JPMorgan wrote customer complaints, was registered both as a broker and an adviser while at JPMorgan.) I am not sure that everything described in these orders involved fiduciary advisers, but certainly a lot of it did, since much of it occurred in discretionary accounts in which JPMorgan advisers could choose investments for their clients and owed those clients fiduciary duties. There has been a lot of talk recently about whether brokers who give investment advice should be fiduciaries, which would require them to put their clients' interests ahead of their own. The Department of Labor has a proposed rule about it for brokers who advise certain retirement accounts. This case is a good reminder that fiduciary duties aren't magical: Even a fiduciary is still in that basic capitalist position of trying to help her clients while also trying to make money off of them. Conflicts are unavoidable, and all you can ask for is good disclosure and a certain generosity of spirit.

You could read the Abacus case as more or less this sort of thing, though it's strictly speaking about misrepresentations, not conflicts of interest. Of course, today's JPMorgan settlement is also, strictly speaking, about misrepresentations.

Seriously, what?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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